Topics to be covered…

• Effects of temporary and permanent

changes in monetary and fiscal policies.
PP542
• Adjustment of the current account over
time.
Effects of Monetary
and Fiscal Policy

K. Dominguez, Winter 2010 2

Temporary Changes in
Temporary Changes in Monetary Policy
Monetary and Fiscal Policy

• Monetary policy: policy in which the central bank
influences the supply of monetary assets.
 Monetary policy is assumed to affect asset markets first.
• Fiscal policy: policy in which governments
(fiscal authorities) influence the amount of
government purchases and taxes.
 Fiscal policy is assumed to affect aggregate demand and
output first.
• Temporary policy changes are expected to be
reversed in the near future and thus do not affect
expectations about exchange rates in the long run.
• An increase in the quantity of monetary assets
supplied lowers interest rates in the short run,
causing the domestic currency to depreciate
(a rise in S).
S)
 The AA shifts up (right).
 Domestic products relative to foreign products are
cheaper so that aggregate demand and output
increase until a new short run equilibrium is
achieved.

K. Dominguez, Winter 2010 3 K. Dominguez, Winter 2010 4

Effects of a Temporary Increase in

Temporary Changes in Fiscal Policy
the Money Supply

• An increase in government purchases or a

decrease in taxes increases aggregate
demand and output in the short run.
 The DD curve shifts right.
 Higher output increases demand of real monetary
assets,
 thereby increasing interest rates,
 causing the domestic currency to appreciate
(a fall in S).
K. Dominguez, Winter 2010 5 K. Dominguez, Winter 2010 6

1
 Effects of a Temporary Fiscal
Recent Temporary Stimulus Packages
Expansion

K. Dominguez, Winter 2010 7 K. Dominguez, Winter 2010 8

Fiscal Expansions Growth Effects of Fiscal Stimulus

(percent GDP, change with respect to pre-crisis year 2007) (deviation from baseline in percentage points)

K. Dominguez, Winter 2010 9 K. Dominguez, Winter 2010 10

WEO Global Growth Projections WEO Global Growth Projections

(with and without estimated G-20 Fiscal Stimulus) (with and without estimated G-20 Fiscal Stimulus)

K. Dominguez, Winter 2010 11 K. Dominguez, Winter 2010 12

2
 Fiscal Multipliers
U.S. Stimulus Package Impact Effects
(depending on deficit expectations)

K. Dominguez, Winter 2010 13 K. Dominguez, Winter 2010 14

Maintaining Full Employment After a

Policies to Maintain Full Employment Temporary Fall in World Demand for
Domestic Products
Temporary fall in world demand
• Resources used in the production process can for domestic products reduces
output below its normal level
either be over-employed or underemployed. Temporary fiscal policy could reverse
the fall in aggregate demand and
• When resources are used effectively and sustainably, output
economists say that production is at its potential or
natural level
level. Temporary
monetary
 When resources are not used effectively, resources are expansion could
depreciate the
underemployed: high unemployment, few hours worked, idle domestic
equipment, lower than normal production of goods and currency
services.
 When resources are not used sustainably, labor is over-
employed: low unemployment, many overtime hours, over-
utilized equipment, higher than normal production of goods
and services.

K. Dominguez, Winter 2010 15 K. Dominguez, Winter 2010 16

Policies to Maintain Full Employment After Policies to Maintain Full Employment

a Money Demand Increase (cont.)

• Policies to maintain full employment may seem easy

Temporary monetary policy could
increase money supply to match
in theory, but are hard in practice.
money demand
1. We have assumed that prices and expectations do
g but p
not change, people
p may y anticipate
p the effects of
IIncrease in
i money
demand raises policy changes and modify their behavior.
interest rates and
appreciates the  Workers may require higher wages if they expect overtime
domestic currency
and easy employment, and producers may raise prices if
they expect high wages and strong demand due to
monetary and fiscal policies.
 Fiscal and monetary policies may therefore create price
Temporary fiscal policy could changes and inflation thereby preventing high output and
increase
aggregate demand and output employment: inflationary bias
K. Dominguez, Winter 2010 17 K. Dominguez, Winter 2010 18

3
 Policies to Maintain Full Employment Permanent Changes in Monetary and
(cont.) Fiscal Policy

2. Economic data are difficult to measure and to
understand.
 Policy makers can not interpret data about asset markets
and aggregate demand with certainty, and sometimes they
make mistakes.
• “Permanent” policy changes are those that
are assumed to modify people’s expectations
about exchange rates in the long run.

3. Changes in policies take time to be implemented

and to affect the economy.
 Because they are slow, policies may affect the economy
after the effects of an economic change have dissipated.

4. Policies are sometimes influenced by political or

bureaucratic interests.
K. Dominguez, Winter 2010 19 K. Dominguez, Winter 2010 20

Short-Run Effects of a Permanent

Permanent Changes in Monetary Policy
Increase in the Money Supply

• A permanent increase in the quantity of

monetary assets supplied
 lowers interest rates in the short run and makes A permanent increase
in the money supply
people expect future depreciation of the domestic decreases interest
rates and causes
currency, increasing the expected rate of return on people to expect a
foreign currency deposits. future depreciation,
leading to a large
 The domestic currency depreciates more than actual depreciation

(S rises more than) the case when expectations

are constant.
 The AA curve shifts up (right) more than the case
when expectations are held constant.
K. Dominguez, Winter 2010 21 K. Dominguez, Winter 2010 22

Effects of Permanent Changes in Long-Run Adjustment to a Permanent

Monetary Policy in the Long Run Increase in the Money Supply
Higher prices make domestic products
more expensive relative to foreign goods:
• With employment and hours above their reduction in aggregate demand

normal levels, there is a tendency for wages

to rise over time. Higher prices reduce
real money supply,
• With strong demand of goods and services Increasing interest
and with increasing wages, producers have rates, leading to a
domestic currency
an incentive to raise prices over time. appreciation

• Both higher wages and higher output prices In the long run,
output returns
are reflected in a higher level of average to its normal
prices. level, and we
also see
overshooting:
• What are the effects of rising prices? E1 < E3 < E2

K. Dominguez, Winter 2010 23 K. Dominguez, Winter 2010 24

4
 Effects of Permanent Changes in Effects of Permanent Changes in
Fiscal Policy Fiscal Policy (cont.)

• A permanent increase in government purchases or • If the change in fiscal policy is expected

reduction in taxes to be permanent, the first and second
 increases aggregate demand effects exactly offset each other, so that
 makes people expect the domestic currency to appreciate in
the short run due to increased aggregate demand, thereby
output remains at its potential or natural
reducing the expected rate of return on foreign currency (or long run) level.
deposits and making the domestic currency appreciate.
• We say that an increase in government
• The first effect increases aggregate demand of
domestic products, the second effect decreases
purchases completely crowds out net
aggregate demand of domestic products (by making exports, due to the effect of the
them more expensive). appreciated domestic currency.
K. Dominguez, Winter 2010 25 K. Dominguez, Winter 2010 26

U.S. Federal Outlays as a Percentage of

GDP

• Average over the past half century: 20.2%

• In 2007, the year before the crisis: 20%
• In 2009,, from the Obama budget:
g 27.2%
• Average 2010-19, in Obama budget: 22.6%
• In 2019, last year of Obama budget: 22.6%

K. Dominguez, Winter 2010 27 K. Dominguez, Winter 2010 28

IMF Estimates of Crowding Out Effects U.S Top Tax Rates

http://www.imf.org/external/pubs/ft/spn/2009/spn0903.pdf
K. Dominguez, Winter 2010 29 K. Dominguez, Winter 2010 30

5
 Effects of a Permanent Fiscal Macroeconomic Policies and the Current
Expansion Account

An increase in • To determine the effect of monetary and fiscal policies

government
purchases raises on the current account,
aggregate demand
 derive the XX curve to represent the combinations of output
and exchange rates at which the current account is at its
desired level
level.
Temporary fiscal
expansion outcome
• As income from production increases, imports
When the increase of increase and the current account decreases when
government purchases
is permanent, the other factors remain constant.
domestic currency is
expected to • To keep the current account at its desired level, the
appreciate, and does
appreciate. domestic currency must depreciate as income from
production increases: the XX curve should slope
upward.
K. Dominguez, Winter 2010 31 K. Dominguez, Winter 2010 32

How Macroeconomic Macroeconomic Policies

Policies Affect the Current Account and the Current Account (cont.)

• The XX curve slopes upward but is flatter than

the DD curve.
 DD represents equilibrium values of aggregate
demand and domestic output
output.
 As domestic income and production increase,
domestic saving increases, which means that
aggregate demand (willingness to spend) by
domestic residents does not rise as rapidly as
income and production.

K. Dominguez, Winter 2010 33 K. Dominguez, Winter 2010 34

Macroeconomic Policies Macroeconomic Policies and the Current

and the Current Account (cont.) Account (cont.)

 As domestic income and production increase, the
domestic currency must depreciate to entice
foreigners to increase their demand of domestic
products in order to keep the current account (only
one component of aggregate demand) at its
desired level—on the XX curve.
 As domestic income and production increase, the
domestic currency must depreciate more rapidly to
entice foreigners to increase their demand of
domestic products in order to keep aggregate
demand (by domestic residents and foreigners)
equal to production—on the DD curve.
K. Dominguez, Winter 2010
• Policies affect the current account through
their influence on the value of the domestic
currency.
 An increase in the quantity of monetary assets
supplied depreciates the domestic currency and
often increases the current account in the short
run.
 An increase in government purchases or decrease
in taxes appreciates the domestic currency and
often decreases the current account in the short
run.
35 K. Dominguez, Winter 2010 36

6
 How Macroeconomic Value Effect, Volume Effect and the
Policies Affect the Current Account J-curve
An increase in the money supply shifts up the AA
curve and depreciates the domestic currency,
increasing the current account above XX.
• If the volume of imports and exports is fixed in the
short run, a depreciation of the domestic currency
 will not affect the volume of imports or exports,
A temporary
p y
fiscal  but will increase the value/price of imports in domestic
expansion currency and decrease the current account: CA ≈ EX – IM.
shifts the
DD and  The value of exports in domestic currency does not change.
appreciates
the domestic
currency, • The current account could immediately decrease after
decreasing
the CA a currency depreciation, then increase gradually as
below XX.
the volume effect begins to dominate the value effect.
Because the AA curve also shifts,
a permanent fiscal expansion
decreases the CA more.
K. Dominguez, Winter 2010 37 K. Dominguez, Winter 2010 38

Value Effect, Volume Effect and the J-

The J-Curve curve (cont.)

• Pass through from the exchange rate to import

volume effect prices measures the percentage by which import
dominates prices change when the value of the domestic
value effect currency changes by 1%.
Immediate • In the DD-AA model, the pass through rate is 100%:
effect of real J-curve: value import prices in domestic currency exactly match a
depreciation
on the CA
effect dominates depreciation of the domestic currency.
volume effect
• In reality, pass through may be less than 100% due to
price discrimination in different countries.
 firms that set prices may decide not to match changes in the
exchange rate with changes in prices of foreign products
denominated in domestic currency.
K. Dominguez, Winter 2010 39 K. Dominguez, Winter 2010 40

Value Effect, Volume Effect and the J-

curve (cont.)
IS-LM Model

• In the DD-AA model, we assumed that investment

• If prices of foreign products in domestic currency do
expenditure is determined by exogenous business
not change much because of a pass through rate less
decisions.
than 100%, then the
 value of imports will not rise much after a domestic currency • In reality,
y the amount of investment expenditure
p
depreciation, and the current account will not fall much, depends on the interest rate.
making the J-curve effect smaller.  Investment projects use saved or borrowed funds, and the
 volume of imports and exports will not adjust much over time relevant interest rate represents the (real) cost of spending or
since domestic currency prices do not change much. borrowing those funds.
 A higher interest rate means less investment expenditure.
• Pass through of less than 100% dampens the effect
of depreciation or appreciation on the current account. • The IS-LM model predicts that investment expenditure
is inversely related to the relevant interest rate.
K. Dominguez, Winter 2010 41 K. Dominguez, Winter 2010 42

7
 IS-LM Model (cont.) IS-LM Model (cont.)

• The IS-LM model also allows for consumption • The IS-LM model expresses aggregate demand as:
expenditure and expenditure on imports to D = C(Y – T, R-πe ) + I(R-πe)+ G + CA(EP*/P, Y – T, R-πe )
depend on the interest rate.
 A higher interest rate makes saving more attractive Consumption Investment Government Current account as
as a function as a function purchases a function of the real
and consumption expenditure (on domestic and of the real exchange rate,
of disposable are
foreign products) less attractive. income and the interest rate exogenous disposable income
real interest R-πe and the real interest
 However, the effect of the interest rate is much rate R-πe rate R-πe

larger on investment expenditure than it is on

consumption expenditure and imports. • Or more simply:
D = D(EP*/P, Y – T, R-πe, G)
K. Dominguez, Winter 2010 43 K. Dominguez, Winter 2010 44

IS-LM Model (cont.) IS-LM Model (cont.)

• Instead of relating exchange rates and output, the

IS-LM relates interest rates and output.
• Y = D(EeP*/P(1+R–R*) , Y – T, R-πe, G)

• In equilibrium, aggregate output = aggregate demand  This equation describes the IS curve: combinations
of interest rates and output such that aggregate
 Y = D(EP*/P,
( , Y – T,, R-πe, G))
d
demand d equals
l aggregatet output,
t t given
i values
l off
• In equilibrium, interest parity holds exogenous variables Ee,P*,P, R*,T, πe, and G.
 R = R* + (Ee-E)/E
 Lower interest rates increase investment demand
 E(1+R) = ER* + Ee (and consumption and import demand), leading to
 E(1+R–R*) = Ee higher aggregate demand and higher aggregate
 E = Ee/(1+R–R*) output in equilibrium.
 The IS curve slopes down.
K. Dominguez, Winter 2010 45 K. Dominguez, Winter 2010 46

IS-LM Model (cont.) IS-LM Model (cont.)

• In equilibrium, the quantity of real monetary Output markets Money market

assets supplied matches the quantity of real are in equilibrium is in equilibrium
Interest
monetary assets demanded: Ms/P = L(R,Y) rate, R
LM
 This equation
q describes the LM curve:
combinations of interest rates and output such that Both the output
the money market is in equilibrium, given values of markets and money
exogenous values P and Ms. 1 market are in
R1 equilibrium at R1
 Higher income is predicted to cause higher and Y1
demand of real monetary assets and higher
interest rates in the money market.
 The LM curve slopes up.

K. Dominguez, Winter 2010 47 K. Dominguez, Winter 2010

Y1 Output, Y 48

8
 Effects of Temporary Changes in the Effects of Permanent Changes
Money Supply (cont.) in the Money Supply in the Short Run
Temporary
increase Expected return Permanent
Expected return in money on foreign currency increase
LM1 LM1
on foreign currency Interest rate, R supply deposits Interest rate, R in money
deposits supply
LM2 LM2
1 1
1´ 1´
R1 R1
3
3´ R3
2 2
R2 R2
2´ 2´

Domestic currency
is expected
to depreciate

E2 E1 Y1 Y2 Output, Y E3 E2 E1 Y1 Y2 Y3 Output, Y
Exchange rate, E ( increasing) Exchange rate, E ( increasing)

K. Dominguez, Winter 2010 49 K. Dominguez, Winter 2010 50

Effects of Temporary Changes in Fiscal Effects of Permanent Changes in Fiscal

Policy Policy
Expected return Expected return
on foreign currency on foreign currency
deposits Interest rate, R LM deposits Interest rate, R LM

Temporary Permanent
2´ R2 fiscal 2´ R2 fiscal
2 2
expansion expansion
1´ R1 1 1´ 3´ R1 1

Domestic currency
is expected to appreciate

E1 E2 Y1 Y2 Output, Y E1 E2 E3 Y1 Y2 Output, Y
Exchange rate, E ( increasing) Exchange rate, E ( increasing)

K. Dominguez, Winter 2010 51 K. Dominguez, Winter 2010 52